Commentary, information, and intelligent discourse about the Irish economy

Mortgage term as a credit condition

The aim of this post is to introduce the topic of mortgage term to maturity in an Irish setting. I will outline how mortgage terms were highly pro-cyclical during the pre-2008 expansion, and that they were used by credit-hungry borrowers to make high-leverage strategies more affordable on a monthly basis. It is well established that credit conditions, as measured by Loan to Value ratios (LTV), Loan to Income ratios (LTI) and Debt Service Ratios (DSR, ratio of monthly repayments to net income) reached unsustainable levels in Ireland in the run-up to the 2008 crash.[1] By contrast terms have received much less attention. Previous work by McCarthy and McQuinn (2013) on Irish credit conditions is the only piece known to me which contains an analysis of mortgage terms. They show that median terms increased rapidly in the 2000-2008 period, and did not decrease after the housing market crash. Further, they show that terms were higher for First Time Buyers, and that longer terms are correlated with an easing in other credit conditions. Today’s post concerns recent analysis carried out by my colleague Edward Gaffney which looks at the distribution of mortgage terms for loans originated between 1997 and 2014.

Why should mortgage terms be of interest to us? Firstly, they can have a huge impact on mortgage affordability. Identical loans, for identical houses, to people with identical incomes, at identical interest rates, can have widely varying monthly repayments driven by varying terms. As a simple example, a loan for €250,000 at an annual rate of 4.5 per cent has a monthly repayment of €1,581 when taken out over 20 years, which falls to €1,183 when that loan is extended to 35 years. A saving not to be sniffed at!

Secondly, they appear to have associations with risk-taking behaviour. Research from Central Bank colleagues[2] has shown that, controlling for a range of factors associated with higher credit risk, mortgages with longer terms are more likely to default, even though a longer term allows for a lower monthly mortgage repayment, all else equal!

Finally, terms also have a big impact on banks’ profitability, as longer term loans will have higher lifetime interest income for the bank. Further, longer terms allow banks to make larger loans while continuing to respect any Debt Service to Income rules that may be in place.

So what can we say about mortgage terms in Ireland? In all that follows, I will focus on the First Time Buyer (FTB) segment of the mortgage market. Our first figure (Fig 1) provides clear evidence from Edward’s work that mortgage terms lengthened significantly during the boom phase in Ireland. Of the 1997 cohort still outstanding in 2014, 60 per cent were originated with terms of 20 years or less, with 90 per cent having terms under 25 years. At the turn of the millennium, the 35 year mortgage was close to non-existent. However, its proliferation through the period of rapid credit growth was quite remarkable, moving to a market share of roughly 50 per cent by 2006-07, with a further 5 per cent of the market taking terms between 35 and 40 years.

While Kelly, McCann and O’Toole (2015) report that credit conditions tightened considerably in the aftermath of the financial crisis, Edward’s chart shows that “credit tightening” in mortgage terms has been much less stark, with 60 per cent of mortgages originated in 2014 still having terms above 30 years.

Fig 1: The distribution of originated mortgage terms per year, First Time Buyer segment 1997 to 2014.

This evidence of a structural shift towards longer terms begs a number of questions relating to the role of term as a credit condition. Figure 2a from Edward’s work provides conclusive evidence that, during the boom phase, longer terms were associated with higher leverage. In 2007, those taking out 40 year mortgages had an average LTV of over 90, with LTVs of 85, 72, 60 and 50 as we move in five-yearly intervals down to 20 year mortgages. While these LTVs have converged since the crisis, the rank ordering persists. Figure 2b completes the picture by showing that borrowers on different terms have in fact been accessing similarly valued houses, which implies of course that those with longer terms were taking out larger average loans. Taken together, these figures strongly suggest that term was being used by FTBs to mount the property ladder at as high a point as possible for a given down-payment amount, using higher originating LTVs to access valuable housing with small down-payments and large loans, while easing the monthly repayment burden of this high-leverage strategy via longer terms.

Figure 2: Average LTV and property value for mortgages originating at different terms.

(a) LTV

(b) Average Property Value

Our next piece of evidence links borrowers’ incomes to mortgage terms. Figure 3 reports clear differences in originating Loan to Income ratios (LTI) across term groups. Those on 40 year mortgages in 2007 were accessing loans with an average LTI of 5, while the equivalent number was under 3 for those with 20 year mortgages, again providing strong evidence that mortgage terms were used as part of a broad “credit conditions package” by credit-hungry borrowers. Figure 3(b) confirms that this highly-indebted strategy was in fact more common among high-income borrowers in the run-up to 2008, with median incomes falling as terms shorten. The one exception to this rule is the 40-year mortgage, which appears to have been popular among lower-income households with extremely high LTIs during its short existence.

Figure 3: Average LTI and income for mortgages originating at different terms.

(a) Loan to Income ratios

(b) Incomes (median)

So where did this “credit condition package” leave borrowers on a monthly basis? It is unclear from the above whether long terms acted to offset the affordability difficulties brought on by high-leverage strategies. To do this, Edward calculates a monthly repayment to gross income (RTI) ratio for each loan in the data, applying an indicative opening interest rate. The evidence is conclusive: despite the fact that longer terms mechanically improve mortgage affordability by lowering repayments all other things equal, it was still the case up to 2008 that borrowers with longer terms were taking out such large loans that their RTIs were in fact higher than borrowers with shorter terms. This is likely part of the explanation for the finding of Kelly, O’Malley and O’Toole (2015) that longer-term mortgages have higher default probabilities, even after controlling for a range of explanatory factors.

More posts on the mortgage market in Ireland to follow over the coming months.